Acquire a company, improve its management, and sell it several years later. This is a common description of PE funds, but it does not explain who provides capital, bears risk, or earns what.

Understanding the PE fund business model requires separating three cash flows: portfolio-company profits, the fund's investment returns, and the manager's compensation.The familiar “2 and 20” describes the last of these—manager compensation. It does not promise investors a 20% annual return.

1. What is a PE fund? This article focuses on buyouts

PE stands for Private Equity, broadly meaning investment in unlisted shares. VC and growth equity also fall within this broad field. In Japan, however, “selling a company to a PE fund” often means a buyout fund acquiring control, so this article focuses on that model.

Explanation of the US SEC also distinguishes buyout PE, which acquires control and participates in management while using debt, from VC, which typically takes minority stakes in startups and similar companies. Not all PE acquires 100% or necessarily uses borrowing.

Entry routes include founder succession, corporate carve-outs, taking listed companies private, and growth investment. The common goal is to enhance value during ownership and ultimately realize a return.

2. LPs, GPs, and managers: A fund differs from its management company

Pensions, financial institutions, corporations, wealthy individuals, and other fund investors are called LPs, while those making investment decisions and running the fund are called GPs. These terms come from partnership funds; in actual structures, the GP, investment manager, and fee recipient may be separate entities.

Thus, a fund suffering a large investment loss does not necessarily mean its management company reported a loss that year. The fund holds investment assets, while the manager employs professionals and provides investment management services.

Investors do not necessarily transfer their entire pledged amount at once. The pledge is a commitment, and a request to pay when funds are needed is a capital call. For example, a JPY1 billion commitment might be funded with JPY200 million initially and JPY300 million later.Uncalled commitments must also be managed as future funding obligations.

3. “2 and 20”: Percentages of what?

The SEC glossary explains the combination of management and performance fees, giving a 2% annual management fee and 20% of profits as an example of “2 and 20.” This is neither a uniform legal rule nor every fund's fee schedule.

If a JPY10 billion fund charges 2% annually, the management fee is JPY200 million per year. However, this is not the professionals' take-home pay. It funds personnel, offices, systems, and deal sourcing. If the fund separately pays audit or external adviser costs, investors' total costs also exceed management fees.

4. What happens to management fees after the investment period?

The same 2% produces JPY200 million annually on JPY10 billion of commitments but JPY120 million on JPY6 billion invested. If the remaining investment balance later falls to JPY3 billion, a 2% charge on that balance is JPY60 million annually.Check the fee base before the percentage.

Some structures use commitments during the investment period, then switch to the acquisition cost of unrealized investments or reduce the rate afterward. The principles of LP industry association ILPA also advocate reducing management fees after the investment period. These are recommended practices, not terms automatically applicable to every fund.

It is therefore inaccurate to assume a 10-year fund charges “JPY10 billion × 2% × 10 years = JPY2 billion.” Total fees can be estimated only after checking each period's base and rate, extension terms, and offsets against other fees.

5. Performance fees are more than “20% of sale gains”

For illustration, suppose total contributions are JPY10 billion, with JPY9 billion invested and JPY1 billion spent on management fees and other costs, and investments realize JPY15 billion. If the contract allocates 20% carry on whole-fund profit after costs and return of all contributions, profit is JPY5 billion, carry is JPY1 billion, and total LP distributions are JPY14 billion.

This hypothetical excludes hurdles, the GP's own investment, taxes, reinvestment, and distribution timing. It differs from looking only at JPY9 billion invested and JPY15 billion recovered and calculating 20% of JPY6 billion.

A key practical feature is the distribution order, called thewaterfall. It is a sequence such as returning capital, giving LPs a preferred return, then sharing profits with the GP. The preferred-return threshold is called the hurdle, but it is not a guaranteed deposit rate. Without distributable proceeds, the stated return may not be received.

Applying carry only above the hurdle differs from a structure with acatch-up, which allocates more to the GP after the preferred return so its share catches up to a specified proportion of a broader profit pool. The same “20%” can therefore produce different outcomes.

Some structures pay performance compensation early, deal by deal; others wait until capital and other amounts are recovered across the fund. Early investments may succeed while later ones lose money. The mechanism for returning excess carry paid earlier is aclawback. ILPA also emphasizes clear distribution priorities, expense deductions, and repayment obligations.

6. How is enterprise value increased?

Describing PE simply as “buy low, sell high” omits the work during ownership: improving sales processes, repricing, strengthening recruitment, closing unprofitable operations, acquiring distribution or technology through add-on acquisitions, expanding overseas, and building management systems so the business no longer depends on its founder alone. Such measures form the investment thesis.

CVC's published approach to value creation plans also emphasizes analyzing performance drivers, actionable measures, appropriate management, and execution involving frontline teams. Simply writing “increase sales” is not a plan.

However, cost cutting does not invariably create value. Excessive cuts to R&D or people sacrifice competitiveness for short-term earnings. Repeated acquisitions can destroy value if integration lags. The question is whether earnings improvement is temporary or sustainable.

7. Debt changes investment returns even with unchanged enterprise value

Suppose a company with enterprise value of JPY1 billion is acquired using JPY400 million of fund equity and JPY600 million of acquisition debt. If business cash generation reduces debt to JPY300 million and the company is sold at enterprise value of JPY1 billion, equity value is JPY700 million. In simplified terms, the initial JPY400 million becomes JPY700 million.

Conversely, if debt remains JPY600 million and enterprise value falls to JPY700 million, equity is worth JPY100 million. A 30% enterprise-value decline becomes a 75% decline in the equity investment. This is leverage. Both examples exclude surplus cash, fees, taxes, and other items.

Debt-driven return amplification and improvement in the business itself must be assessed separately.Capital expenditure and working capital needed to generate repayment cash cannot simply be depleted. Interest, maturity, and refinancing terms also constrain business flexibility.

8. Exits are not only IPOs: Sales to another fund are possible

Exits include sales to strategic buyers, sales to other PE funds, and IPOs. An IPO date is not necessarily the date all shares are converted to cash. Shares may be sold later depending on lockups and market conditions.

The same manager may also create a continuation fund and transfer a portfolio company from the existing fund. Even if continued ownership is rational, having the same manager on both sides creates conflicts over pricing and costs. Information and procedures enabling existing LPs to choose between cashing out and continuing are important.

Funds have finite lives. A good company is not necessarily held forever. For an owner-manager selling a business, the immediate price matters alongside who will manage it, the growth plan, and the anticipated future buyer.

9. Managers' and investors' interests are not perfectly aligned

Carry helps align investors and managers. However, fees linked to fund size also motivate managers to grow assets. Good investment opportunities may not increase proportionally with fund size.

Separate transaction or monitoring fees received from portfolio companies, expense allocation across funds, and related-party transactions also require attention. The SEC's investor guidance identifies such costs and conflicts as matters to examine.

LPs should check management-fee offsets, key-person departure provisions, changes in investment policy, extensions, and valuation methods. A manager's own investment improves alignment but does not resolve every conflict.

10. Assess multiples, annualized returns, and cash recovered together

Turning JPY100 million into JPY200 million means different things over 3 years versus 10. With one initial investment and one final receipt, the annualized return is approximately 26% over 3 years and 7% over 10. IRR incorporates investment and distribution timing.

A manager's claim of “doubling” may include valuations of unsold companies. Alongside the investment multiple, check actual distributions, unrealized valuations, and LP net proceeds after fees and carry. Borrowing that delays LP contributions changes IRR, so IRR does not necessarily reflect only portfolio-company performance.

The key to understanding PE is: Who uses whose capital, improves what, realizes value on what terms, and divides the proceeds how?Both business sellers and fund investors benefit from understanding this structure. “2 and 20” is only one part of the picture.